At Delancey Street, we talk to a lot of business owners who are out of cash and are asking themselves, is Chapter 11 the way out of my situation? A Chapter 11 case is not free to run. When the business is out of money, the money usually comes from a secured lender, either by letting the business use its cash collateral, or by lending the money as DIP financing. That money does not come for free, and below are five ways the business pays.
In both cases, even if the lenders agree, they can often impose a long laundry list of conditions to protect the secured creditors. This has led some to speculate that more Chapter 11 cases are now ending in liquidation, and experts say there is a trend toward liquidation in large Chapter 11s. One example that gets cited is Circuit City, where 34,000 people lost their jobs in the liquidation. Some put the blame squarely on the secured lenders. The lenders curtailed funding during the bankruptcy, and extended only $50 million, including $30 million in fees, which came with a short window to sell the company and a right to declare default at almost any time.
The “Price” of the Funding
When a business files Chapter 11, the “price” of the funding it receives to operate isn’t just interest. The DIP financing or cash collateral use is usually conditioned on a list of protections that secured creditors demand in order to take the risk of lending money after the filing. Each of the five things below is something a lender may ask for in exchange for granting Chapter 11 financing. Not every case will have all five, but you should know what terms are on the table before you agree to anything.
The first price is the roll-up. Sometimes a pre-petition secured debt (the old loan from before the filing) will be rolled up into a DIP facility. There are two ways this can happen. First, the agreement with the DIP lender may require all payments made post-petition to go first to paying the pre-petition debt. Second, the DIP may be made in one lump sum, some of which pays off the old secured debt. If the lender is over-secured (i.e., the collateral has a value greater than the debt) the court may allow this. If it is under-secured, the lender should not be allowed to improve its position at the expense of unsecured creditors.
The second price is a release. Pre-petition secured creditors often require the debtor to release claims against the creditor. Such a release may ask the debtor to agree that (1) the old lender’s claim is valid, has priority, and is in the amount alleged, and (2) the debtor waives any defenses or claims against the old lender, including preference and fraudulent conveyance claims and other avoidance actions. Most courts will permit the debtor to waive these claims, but the unsecured creditors committee has the right to object and say it is not bound by the release. However, the trend is to limit the time the committee has to investigate and pursue claims against the old lender.
The third price is professional fees. DIP and cash collateral orders often put a lien on all of the debtor’s free assets, and give the lender a super-priority administrative claim. As a result, the lender has to agree to a carve-out from its lien so that the debtor’s lawyers and the unsecured creditors committee’s professionals can be paid. Lenders may set tight limits on those fees, allowing them to put a bridle on how long the Chapter 11 case lasts, and limiting how much of a look into their conduct the professionals can conduct. Any money set aside to investigate the lender is often very specifically limited in scope.
Fourth price: avoidance actions and 506(c). Under Chapter 5 of the Bankruptcy Code, recoveries from preference, fraudulent conveyance and other avoidance actions historically have been available for the benefit of all unsecured creditors in most Chapter 11 cases. But increasingly lenders are demanding a lien on such recoveries, or an order that makes the recoveries available for payment of the DIP lender’s super-priority claim. Separately, Section 506(c) allows reasonable and necessary expenses incurred in preserving or disposing of a lender’s collateral to be paid out of the proceeds of that collateral in certain circumstances. DIP lenders don’t like that either, and many require the debtor to give up 506(c) surcharges.
Fifth price: control. The use of DIP financing and cash collateral is generally conditioned on the debtor providing extensive financial information and sticking to projected budgets, including the achievement of certain income and expense targets. Trigger dates are frequently included, such as a date by which the assets must be sold or a plan acceptable to the DIP lender must be filed. Finally, some DIP lenders insist that if the debtor breaches the order, the lender gets relief from the automatic stay without another order or hearing.
Local Rules
Many courts frown on these conditions. Some courts, including the bankruptcy court in Delaware, have local rules requiring that terms such as cross-collateralization, roll-ups, binding the estate on the lien of the old lender, or waiving claims without the time or opportunity to investigate, waiving 506(c) without notice, applying the carve-out differently for committee professionals, or priming a lien without the consent of the lienholder be conspicuously disclosed. Even so, such terms are still being approved once they have been disclosed and the court has considered them.
We are not a law firm. Here is a big takeaway if you are looking to fund a Chapter 11 filing: the lender that provides the money gets a lot of control over how your case is run and resolved. Read the terms and understand them before you file. When bankruptcy is the right move, as in a Subchapter V, we refer owners to an independent bankruptcy attorney. When a settlement with funders and lenders for less than the full balance makes more sense, that is what we do. The first consultation is free and confidential. On the first call, we tell you if a cheaper option exists.
